You have probably heard a lot about shorting stocks lately, if not before surely when it became banned to short financial stocks for a while during the bank crisis of ’08. So what does it mean and how do you go about shorting stocks and what risks are accompanied with it?
Since stock trading have become something you do in front of your computer screen at work or at home, you have surely seen a lot of alternatives to the traditional “buying of stocks”. One such alternative is called shorting stocks and is widely available among the various online brokers today.
Shorting is defined as an activity where one person borrows a certain number of stocks, sells them, and after a while buys them back to keep the difference in the price gotten when selling them and buying them back. Confusing? Here’s an example procedure for shorting stocks.
1) Joe believes the market is about to take a down turn. He belives Goldman Sachs (GS) will drop in price and therefor borrows 1,000 shares from his online broker.
2) Joe immediately sells the stocks that he borrowed for $100 / share.
3) Joe receives the money – $100,000 minus commission.
4) One week later (doesn’t have to be a week, it can be 5 minutes or 10 weeks even) GS has dropped to $90 / share and Joe buys 1,000 shares of GS paying $90,000 + commission.
5) Joe gives back the GS shares he just bought to his online broker that lent him the stocks to begin with.
6) Joe have made a $10,000 – commission for two deals in profit from GS dropping from $100 to $90 per share. He also need to deduct a cost for borrowing the share to his broker.
So, the above procedure outlines what shorting stocks is all about; making money from a price reduction in a stock or index. However, the keywords to take note of here, before going out to your broker and wanting to short stocks are high risk and hidden costs. Let’s examine the costs on the transactions taking place in our example above.
In the example, Joe needs to pay commission twice and also need to pay interest rate for the borrowed stocks. So, more realistically, a profit for about $9,000 in total is more like it. So, in order to make any real money from shorting stocks, you need to have a good amount of money to begin with, to not get eaten by interest rates and commissions.
Alternatives to Shorting
We’ve concluded that shorting is risky business. If the market turns against you when in a short position, you get hit in more than one way since the interst rate on the borrowed stock is ticking away.
So what’s a regular joe to do?
Well, instead of trying to trade like a proffessional, you can take the safer track going with Exchange Traded Funds so called ETF’s that have gained hugely in populraity of late. There are ETF’s for both bulls and bears and with various leverage fitting your risk profile.
Now you should know what shorting means and how to go about it should you want to try it. Be careful though, shorting is very risky.